Money markets are the new interbank markets

Last week, I bemoaned the end of the interbank market — a market which looks like it might never come back, and which certainly hasn’t been done any favors by today’s news that Barclays is paying $453 million to settle allegations that it manipulated the key interbank interest rate.

Now Steven Davidoff has an interesting take on a broader phenomenon — that of money-market funds. There are many big differences between commercial paper, on the one hand, and interbank lending, on the other — but those differences are narrowing, and the commercial paper market has to a first approximation become an entirely financial market, a place for banks and shadow banks to do their short-term borrowing while the interbank market remains closed.

According to David S. Scharfstein of Harvard Business School, who also testified last week, of the 50 largest issuers of debt to money market funds today, only two are nonfinancial firms; the rest are banks and other financial companies, many of them foreign.

Once upon a time, before the financial crisis, money-market funds were a mechanism whereby individual investors could make safe, short-term loans to big corporates, disintermediating the banks. But all that has changed now. For one thing, says Davidoff, “about two-thirds of money market users are sophisticated finance investors”. For another, the corporates have evaporated away, to be replaced by financials. In the corporate world, it seems, the price mechanism isn’t working any more: either you’re a big and safe corporate and don’t want to run the refinancing risk of money-market funds suddenly drying up, or else you’re small enough and risky enough that the money market funds don’t want to lend to you at any price. At this point, money-market funds control just $2.6 trillion, down a whopping $1.7 trillion from the $4.3 trillion they had before the crisis.

This is very similar to what is quite familiar in the interbank market: instead of a market where supply and demand are matched at a certain price, we have a market which simply isn’t clearing — where no deals get done at all. The corporates are out entirely, as are a huge swathe of the retail investors; what’s left is financial investors lending to financial borrowers, taking advantage of the fact that the shadow banking system doesn’t have the same kind of capital adequacy rules that the real banking system has.

All the more reason, then, to regulate these animals with a heavy hand. The industry is screaming blue murder, but the louder they shout, the less compelling they sound. As Davidoff says, the money-market industry’s argument basically comes down to saying that it’s important to make retail investors believe their money is secure, even when it isn’t. And that’s not the kind of argument that any regulator should have any time for.